Forex probe: how to fix the fix

By: Eva Szalay Published on: Friday, November 8, 2013

As the investigation into the alleged manipulation of FX widens, the jury is out on whether the practice is tantamount to front-running clients or simply a case of hedging. Suggested reforms to the benchmark include handing it over to a public body, or banks’ abandoning fixing-related orders altogether and treating the flow as normal business, while others think regulators’ efforts would be better spent reforming the fix in options contracts.

Colluding
to manipulate prices would count as illegal, but simply
moving the fix is not against the rules. Large orders that
asset managers ask to be executed at the fix price naturally
move prices as price discovery takes place.

A pick-up
in volumes, volatility and temporary spikes in currency prices
had been cited as evidence of improper trading
practices.

Increased
volatility is a natural consequence of high volumes  it
does not indicate attempts to manipulate the
fix price, says Pierre Lequeux, an independent
consultant and former head of currency management at Aviva
Investors. It is similar to what happens at the opening
and closing times in stock markets. Its the process of
price discovery.

David
Woolcock, chair of the ACI Committee for Professionalism, adds:
There is no evidence of wrongdoing so far. If banks
have to execute very large client orders in a short
time-period, the price will naturally move.

David Woolcock, chair of the ACI Committee
for Professionalism

Price swings can also be magnified because of the fragmented
nature of currency trading. When buying or selling starts,
smaller players and
high-frequency trading firms jump on the move on electronic
platforms.

The
fix is based on trades in a one-minute window, says Mark
Taylor, dean of Warwick Business School. It doesnt
make sense to concentrate lots of large trades in such a short
time-period. Its easy to see why the price spikes before
settling back again afterwards.

Taylor
adds that the price-setting window should be widened and a
randomized element added, to prevent possibilities of
gaming.

The
window should be an hour long, 30 minutes before the fix and
the same after, with a randomly selected one-minute period then
setting the fix price, he says.

In the
current system, banks have to do the deals and sometimes can
face steep losses. One head of real-money sales at a bank
recounted how impossible it is to deal with fix-related flows.
He says once a client asked for $4 billion to buy against the
Canadian dollar at the fix.

There was no
liquidity for such a large order, he says. We moved
the market by something like three big figures, but there was
nothing we could do.

You
must hedge yourself before the fix. You simply cannot offer to
provide such a large amount of money on your balance sheet.
Its impossible. Thats not front running 
its taking the risk and hedging it, as you are supposed
to do as a bank.

There are
no restrictions on who can trade and what can be traded around
the fix. People with no real orders to execute can just as well
take large punts on the fix as those who are trying to execute
benchmark flows.

You
stick a flag in the ground and say this is something that will
happen every day and you know big volumes are going
through, says an executive at a large bank-only platform.
Its just like a set major data release. People take
positions on it and there is nothing wrong with that.
Thats trading.

Fees

Fix-related flows
might be big but banks dont get paid for executing the
orders as they would in the course of normal
business.

There is
nothing that banks would like more than eliminating the fix and
just getting the flow to execute during the day, getting paid
the spread and getting flow information, says the former
head of electronic FX trading at a large bank.

One issue
is that fee structures in equities and FX are different. In
stock trading, which has a central exchange, clients get
charged a fee for being provided with securities to buy and
sell. In FX, the commission is built into the bid offer spread,
and liquidity providers have to trade currencies before they
can offer a service to clients.

Frederic Ponzo, managing partner at GreySpark
Partners

Execution at the mid-point rate eliminates the fee banks earn
from providing customers with foreign exchange services that is
expressed in the spread. The spread takes market conditions,
creditworthiness and relationships into account when its
calculated how much fees each customer will pay.

If the
trades are executed at midpoint, banks will only get a
commission if they profited from the set price themselves. Is
this front running client orders or just effective hedging?
While in stock trading it would be an open-and-shut case, in
currency markets this is normal hedging practice or, at worst,
a regulatory grey area.

It
is a grey area in terms of regulation, says Frederic
Ponzo, managing partner at GreySpark Partners, a capital
markets consulting company. Regulators would have to
prove intent to manipulate the price, which is very difficult.
There is no clear rule-book that describes acceptable practices
as FX is completely OTC.

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